Review Fiscal Policy Money & Banking
Money, Banking & the Money Supply
Alex Peden
International College of Manitoba
June 29, 2020
Alex Peden ECON1020 - Macro Week 6 Lecture
Review Fiscal Policy Money & Banking
Homework
Assignment #2 available
Due date July 13th
Must be completed before the second midterm.
Test #2 is on July 13th. It will begin at 8am (Winnipeg time),
and it will be conducted on Moodle just like the first midterm.
Alex Peden ECON1020 - Macro Week 6 Lecture
Review Fiscal Policy Money & Banking
Review
Given the following information about an economy, answer the
questions below:
C = 75 + 0.8YD
I0 = 200
G0 = 275
NT = 0.25Y
1 Calculate Y* using the multiplier.
2 Calculate the BB and draw a BB graph showing where the
country’s equilibrium point belongs.
3 Describe the change in Y* that would occur if G decreased by
50?
Alex Peden ECON1020 - Macro Week 6 Lecture
Review Fiscal Policy Money & Banking
Review Exercise
If the government chooses to raise the tax rate:
1 Will the multiplier increase or decrease?
2 Will the budget balance increase or decrease?
Alex Peden ECON1020 - Macro Week 6 Lecture
Review Fiscal Policy Money & Banking
Fiscal Policy
Fiscal policy describes how government’s can use their policy
tools (G0 and t) to improve economic performance
There are two main objectives of fiscal policy:
Stabilize equilibrium Y from business cycles
Close recessionary gaps
Close inflationary gaps
Manage budget deficits and public debt
Sometimes, these goals can be at odds, and policy-makers will
need to choose how to act
Alex Peden ECON1020 - Macro Week 6 Lecture
Review Fiscal Policy Money & Banking
Fiscal Policy - Stabilize Y
How can the government use fiscal policy to close a recessionary
gap? Demonstrate with a graph.
Alex Peden ECON1020 - Macro Week 6 Lecture
Review Fiscal Policy Money & Banking
Fiscal Policy - Stabilize Y
Alex Peden ECON1020 - Macro Week 6 Lecture
Review Fiscal Policy Money & Banking
Fiscal Policy - Stabilize Y
How can the government use fiscal policy to close an inflationary
gap? Demonstrate with a graph.
Alex Peden ECON1020 - Macro Week 6 Lecture
Review Fiscal Policy Money & Banking
Fiscal Policy - Stabilize Y
Alex Peden ECON1020 - Macro Week 6 Lecture
Review Fiscal Policy Money & Banking
Fiscal Policy - Stabilize Y
At equilibrium, leakages = injections
S + NT = G + I
Government uses its fiscal policy tools to:
Increase injections to stabilize a recessionary gap
Increase leakages to stabilize an inflationary gap
Without fiscal policy, the economy should move back towards
equilibrium (as we discussed last week). Fiscal policy can be used
to avoid waiting for this to occur, and smooth transitions.
Alex Peden ECON1020 - Macro Week 6 Lecture
Review Fiscal Policy Money & Banking
Fiscal Policy - Stabilize Y
Fiscal policy takes place in two manners:
Automatic fiscal stabilization
Discretionary fiscal policy
What is the difference between these two?
Alex Peden ECON1020 - Macro Week 6 Lecture
Review Fiscal Policy Money & Banking
Fiscal Policy - Stabilize Y
Fiscal policy takes place in two manners:
Automatic fiscal stabilization occur without political
intervention
Since NT = tY , if incomes begins to fall or rise, NT will
automatically stabilize since the fraction ‘t’ will lead to more or
less leakage
Discretionary fiscal policy occur when governments
intervene in the economy to smooth transitions
Raising or lowering t and G
Alex Peden ECON1020 - Macro Week 6 Lecture
Review Fiscal Policy Money & Banking
Fiscal Policy
Fiscal policy describes how government’s can use their policy
tools (G0 and t) to improve economic performance
There are two main objectives of fiscal policy:
Stabilize equilibrium Y from business cycles
Close recessionary gaps
Close inflationary gaps
Manage budget deficits and public debt
Sometimes, these goals can be at odds, and policy-makers will
need to choose how to act
Alex Peden ECON1020 - Macro Week 6 Lecture
Review Fiscal Policy Money & Banking
Fiscal Policy - Public Debt
Governments do not need to run a balanced budget every year
Government bonds can be issued to finance a negative budget
balance
Public debt (PD) refers to the total value of government
bonds released
Alex Peden ECON1020 - Macro Week 6 Lecture
Review Fiscal Policy Money & Banking
Fiscal Policy - Public Debt
PD = Σ (past BB, both + and -)
Public Debt Ratio = PD/Y
Alex Peden ECON1020 - Macro Week 6 Lecture
Review Fiscal Policy Money & Banking
Exercise
Given the following information about an economy, answer the
questions below:
C = 55 + 0.7YD
I0 = 300
G0 = 280
NT = 0.2Y
1 Use the multiplier to solve for Y*, and draw an AE-Y graph.
2 On your graph, show where YP belongs if there is a
recessionary gap.
3 If the recessionary gap is $300, calculate the change in
Government expenditure needed to close the gap.
Alex Peden ECON1020 - Macro Week 6 Lecture
Review Fiscal Policy Money & Banking
Money
What is money?
Why is it needed?
What alternatives are there?
Alex Peden ECON1020 - Macro Week 6 Lecture
Review Fiscal Policy Money & Banking
Money
Money is:
a medium of exchange
unit of account
store of value
Alex Peden ECON1020 - Macro Week 6 Lecture
Review Fiscal Policy Money & Banking
Money as a Medium of Exchange
Money can be anything that is generally accepted for
payments
Using money lowers transaction costs, makes it easier for
individuals to trade
Alex Peden ECON1020 - Macro Week 6 Lecture
Review Fiscal Policy Money & Banking
Barter Economy
Without money, economies must rely on bartering (trading goods
for other goods)
Trade requires a double coincidence of wants
Trade involves multiple ’exchange ratios’
What do these mean? How does money improve trade and
efficiency?
Alex Peden ECON1020 - Macro Week 6 Lecture
Review Fiscal Policy Money & Banking
Measures of the Money Supply
The monetary base is made up of all bills and coins in
circulation, as well as cash held by banks.
The money supply includes bills and coins in circulation as
well as bank deposits.
Alex Peden ECON1020 - Macro Week 6 Lecture
Review Fiscal Policy Money & Banking
Measures of the Money Supply
Alex Peden ECON1020 - Macro Week 6 Lecture
Review Fiscal Policy Money & Banking
Types of Banks
Commercial banks:
Provide banking services to the public
Profit-oriented, private businesses
Issue bank deposits and lend to customers
Create deposits by their lending activity
Deposits are a medium of exchange
Alex Peden ECON1020 - Macro Week 6 Lecture
Review Fiscal Policy Money & Banking
Types of Banks
Central banks (Bank of Canada)
Not profit-oriented
Regulates money and supports financial markets
Responsible for monetary policy
Banker for commercial banks
Lender of last resort
Banker for the government
Alex Peden ECON1020 - Macro Week 6 Lecture
Review Fiscal Policy Money & Banking
Banking Operations: Money Creation
Under four conditions, the bank can create deposits (money):
1 Non-bank public has confidence in banks, holds & uses bank
deposits as money
2 Non-bank public borrows from the banks
3 The banks operate with fractional cash reserve ratios
4 The banks accept risks involved in lending to the non-bank
public
Alex Peden ECON1020 - Macro Week 6 Lecture
Review Fiscal Policy Money & Banking
Banking Operations: Money Creation
Two important factors determine banks’ money creation:
the currency ratio (cr) describes how the public chooses to
hold their holdings
the reserve ratio (rr) describes how banks choose to hold
their holdings
Alex Peden ECON1020 - Macro Week 6 Lecture
Review Fiscal Policy Money & Banking
Currency Ratio
public cash holdings
cr =
public bank deposits
1 Imagine you have $150 in your wallet and your night-stand.
You also have another $450 in a chequing account. What is
your currency ratio?
2 What about if you withdraw another $150?
3 How can you interpret a currency ratio of 0.1?
4 How does this translate to the entire population?
5 How does the currency ratio affect banks’ ability to lend
money?
Alex Peden ECON1020 - Macro Week 6 Lecture
Review Fiscal Policy Money & Banking
Reserve Ratio
reserve assets
rr =
deposit liabilities
1 If the public deposits $100,000 at a bank, and the bank
chooses not to lend any money out, what is the reserve ratio?
2 Now, if the bank decides to provide a $100,000 loan to a
business, what is the new reserve ratio?
3 What does a reserve ratio of 0.25 mean?
4 How does the reserve ratio affect banks’ ability to lend?
Alex Peden ECON1020 - Macro Week 6 Lecture
Review Fiscal Policy Money & Banking
Exercise
If the public has a currency ratio of 0, and the banks have a
reserve ratio of 0.10, what will happen when the public begins with
$1000? Who will be holding how much money?
Alex Peden ECON1020 - Macro Week 6 Lecture
Review Fiscal Policy Money & Banking
Exercise
1. Initial Position
Bank Assets Bank Liabilities Public Assets Public Liabilities
Cash: 0 Deposits: 0 Cash: $1000 Bank Loans: 0
2. Public deposits cash
Bank Assets Bank Liabilities Public Assets Public Liabilities
Cash: $1000 Dep: $1000 Cash: 0 Loans: 0
- - Dep: $1000 -
3. Banks lend deposits
Bank Assets Bank Liabilities Public Assets Public Liabilities
Cash: $1000 Dep: $10,000 Cash: 0 Loans: $9000
Loans: $9000 - Dep: $10,000 -
Alex Peden ECON1020 - Macro Week 6 Lecture
Review Fiscal Policy Money & Banking
Exercise
What happens to cash and deposits when:
cr = 0
rr = 0.2
Initial cash = $5000
How would the above change if the cr began to rise?
Alex Peden ECON1020 - Macro Week 6 Lecture
Review Fiscal Policy Money & Banking
Banking Operations: Money Creation
Banks will expand their lending & create new deposits when:
they have excess reserves
they can find credit-worthy borrowers
they are willing to accept the risk of lending and issuing
deposits
assuming the public:
has confidence in the safety of bank deposits
is willing to borrow from banks
Alex Peden ECON1020 - Macro Week 6 Lecture
Review Fiscal Policy Money & Banking
Banking Operations: Money Creation
What limits are there on money creation by banks?
Alex Peden ECON1020 - Macro Week 6 Lecture
Review Fiscal Policy Money & Banking
Banking Operations: Money Creation
Behaviour of banks
Higher rr: lowers bank lending and deposit creation
Caution over risks of lending and withdrawal of deposits
Behaviour of public
Higher cr: lowers bank lending and deposit creation
Uncertainty about safety of bank deposits
Uncertainty about future stability of financial markets
Alex Peden ECON1020 - Macro Week 6 Lecture
Review Fiscal Policy Money & Banking
Financial Panics
A financial panic sequence can occur when the public loses
confidence in bank deposits
Customers rush to withdraw deposits, known as a bank run
Banks will call for central bank support
Central bank acts as a lender of last resort
This may lead to government take-over of the bank, and/or
liquidation
Customers may also be protected by deposit insurance
Alex Peden ECON1020 - Macro Week 6 Lecture
Review Fiscal Policy Money & Banking
Banking Operations: Money Creation
Let’s re-visit the four conditions for banks creating deposits:
1 Non-bank public has confidence in banks, holds & uses bank
deposits as money
2 Non-bank public borrows from the banks
3 The banks operate with fractional cash reserve ratios
4 The banks accept risks involved in lending to the non-bank
public
Alex Peden ECON1020 - Macro Week 6 Lecture
Review Fiscal Policy Money & Banking
Money Multiplier
The money multiplier is similar in concept to the AE multiplier.
When initial autonomous spending is increased, the AE
multiplier explains the total effect on overall spending
When the monetary base is increased, the money multiplier
explains the total effect on the money supply
Reminder:
Monetary base (MB): bills and coins in circulation & cash
held by banks
Money supply (M): bills and coins in circulation & bank
deposits
Alex Peden ECON1020 - Macro Week 6 Lecture
Review Fiscal Policy Money & Banking
Money Multiplier
M = MB ∗ money multiplier
1 + cr
Multiplier =
rr + cr
Alex Peden ECON1020 - Macro Week 6 Lecture
Review Fiscal Policy Money & Banking
Exercise
1 + cr
Multiplier =
rr + cr
1 If the monetary base is $5000, how large is the money supply
if the cr = 0 and the rr = 0.2?
2 If the monetary base is $5000, how large is the money supply
if the cr = 0.1 and the rr = 0.2?
Alex Peden ECON1020 - Macro Week 6 Lecture
Review Fiscal Policy Money & Banking
Exercise
1 + cr
Multiplier =
rr + cr
1 What happens to the money multiplier if cr increases?
2 What happens to the money multiplier if rr decreases?
3 In (1) and (2), what happens to the money supply?
Alex Peden ECON1020 - Macro Week 6 Lecture
Review Fiscal Policy Money & Banking
Exercise
How big is the money multiplier in Canada?
MB: $70.6 billion
M: $592.4 billion
What does this number mean?
Alex Peden ECON1020 - Macro Week 6 Lecture
Review Fiscal Policy Money & Banking
Money Supply Function
1 + cr
M0 = ∗ MB0
rr + cr
The money supply depends on three variables:
1 MB - monetary base
2 cr - the public’s currency ratio
3 rr - the bank’s reserve ratio
So if the central bank controls MB, it controls M, provided that cr
and rr are constant.
Alex Peden ECON1020 - Macro Week 6 Lecture
Review Fiscal Policy Money & Banking
Review
Reminder:
Assignment #2 is now available. You have July 13th to complete
it. Please note there is one question that includes a the marginal
propensity to import in a calculation. We will cover this concept
later in the term, but for now, a brief introduction...
You should continue preparations for Test #2 on July 13th.
Alex Peden ECON1020 - Macro Week 6 Lecture
